Patrick Devine offers a personal view of the development of the ART market to date and its relationship with the conventional market and indicates how the market is likely to grow in the new millennium.
The new millennium is fraught with uncertainty but one thing is clear: like it or loathe it, welcome it or not, the alternative risk transfer (ART) market is set fair to make rapid advances in the first decade of the new millennium. Growth in the ART market can only be good for the conventional insurance and reinsurance industry.
Why should this be? Before we can answer that question we need to make some sense out of the phrase “alternative risk transfer” and the market it seeks to describe.
ART is in one sense the bearing of risk by entities outside the insurance industry and can be traced in its development to the trend towards self insurance by corporates and the meteoric growth in the number of captives since the 1950s. This market was fuelled and given a new sense of direction in the 1980s with the introduction of finite risk covers placing an ultimate limit on the liability of the risk taker in a given transaction. Since then it has extended its reach to include a variety of customised insurance related and financial techniques encompassing financial reinsurance, contingent capital, securitisation, catastrophe bonds, credit enhancement and derivatives such as weather swaps.
Alternative or complementary?
“Alternative” implies a choice and that can only be good for the conventional and alternative markets and their clients. Frequently, however, “alternative” is read as implying that the ART market is a threat to or will replace the conventional market and that the products of the conventional market are wholly substitutable by those drawn from the ART market. That is not the case. While there is some overlap, the ART and conventional markets are wholly interdependent and complementary.
Why is this so? The reason is that there will always be risks which by virtue of price, loss experience and transactional costs are more economic to place in the conventional market under traditional indemnity insurance and reinsurance contracts. There are, however, other risks whose characteristics are such that it is more efficient to subject them exclusively to ART treatment. The two markets may be best viewed as two circles which compete only in the areas where they overlap.
The best ART structures, (i.e. those that deliver the maximum value at the best price) involve a combination of conventional (re)insurance and broader ART techniques so as to effect optimal risk transfer at optimal pricing. ART is the equivalent of several more clubs in your golf bag. It does not mean you have to throw away your existing clubs.
The “four C's” of ART
To better understand this market and its prospects for growth we need to look at the “four C's” of alternative risk transfer: the Characteristics of ART when compared to conventional (re)insurance; Capital and the most efficient use of it; the Convergence of the insurance and capital markets, allegedly the real driver behind the ART market and, finally, the Constraints on the growth of the ART market and the likelihood of their removal.
ART is not a product: it is a concept representing a broader approach to risk than that traditionally exhibited by the conventional (re)insurance market and involving products and combinations of products from the conventional (re)insurance market (self-insurance, captives, contracts of indemnity, financial guarantee) banking (letters of credit, loan, project and structured financing) capital markets (bonds, derivatives, securitisation) and corporate markets (put and call options).
By comparison with the conventional (re)insurance market there are a number of characteristics common to most variants of ART, although not necessarily present in each transaction:
ART transactions frequently involve a multi-disciplinary team in order to secure the optimal solution for the client's problem. This will involve members experienced in (re)insurance products and pricing, capital markets, accountants, risk modellers' actuaries, tax advisers and lawyers to help structure the transaction and create enforceable documentation.
Risk is assumed over longer time horizons: multi-year transactions are common in contrast to the traditional “annual renewal” approach of the conventional market.
ART structures can incorporate both the risk specific approach which characterises the conventional market, e.g. indemnity against property/casualty losses, and also a more “holistic” or integrated risk management approach bundling a broad range of specific losses and, increasingly, risks such as operational risks not hitherto considered insurable.
Single, double and treble triggers help specify the risk being transferred and reduce both premium payable and the risk of exposure borne by the ultimate risk carrier.
Conventional covers are bilateral contracts between the insurer and insured or the insurer and reinsurer. ART transactions are often multi-party involving contractual relationships between not only the initial loss bearer and ultimate risk carrier but may also include derivative transactions with counterparties, and arrangements with trustees and others depending upon the structure and the nature of the transaction.
The search for the most certain regulatory and transactional environment leads to the use of a number of different jurisdictions and laws in order to achieve bankruptcy remoteness and certainty in legal, regulatory, tax, and accountancy issues.
The driver behind ART and alternative risk financing (ARF) is access to capital. Hitherto corporates and insurers were able to transfer the traditional classes of insurance risk by reference to only one source of capital: that provided by the insurance industry. Corporates and insurers traditionally accessed capital from other sources for different purposes: from shareholders for equity, from banks for working capital or the acquisition of new business and from the capital markets for hedging purposes. ART and ARF are about securing the optimal use of capital from the different available sources instead of from just one source.ART permits arbitrage between the pricing and the products available in the (re)insurance, banking and capital markets, each with their different cycles, appetite for risk and costs of capital driven by different regulatory requirements.
It is a widely held belief that the future of ART is wholly dependent upon the convergence of the three financial services sectors that have traditionally been separately regulated: (re)insurance, banking and investment. In common with much else that is said about ART this is only half true. If convergence means identical regulatory requirements for each of these three industries this would inhibit the growth of the ART market because it is in the arbitrating of the different costs of capital in each sector, the use of their different products and in an appreciation of their different appetites for risk that the strength of ART lies. What is required is not convergence in this sense but deregulation allowing entities from the three separate financial services sectors to secure vertical integration and the economies of scale associated with that integration.
At present Europe, including the UK, is deregulated in this latter sense. The US, by virtue of the Glass Steagal Act is not. However, most of the capital which has funded the growth in the Bermuda market over the past 15 years - so that last year for the first time the Bermuda market had a higher premium income than Lloyd's with its 300 year trading history - has come from the US. Viewed from one perspective Bermuda had received considerable support in its growth from excessive domestic US insurance regulation. Regulators can move markets, but usually only offshore!
Looking to the year 2000 and beyond, what then are the key constraints on the growth of the ART market? Or, put another way, what prevents the alternative market from becoming mainstream and conventional?
Price is often quoted as the hard line constraint. As long as rates in the conventional (re)insurance market are soft the received wisdom is that growth in the ART market is stalled. This view is not without foundation.
XL Capital in Bermuda - a leading alternative risk transfer player - purchased a catastrophe linked swap to protect its capital against a one in 100 years or one in 200 years event.
This year XL went to market again for the same product only to find that Berkshire Hathaway provided retrocessional coverage at a better cost. Brian O'Hara, president and ceo of XL Capital Ltd. is on record as saying: “As long as Berkshire Hathaway is willing to commit its massive balance sheet to meet the needs of companies like ours, then (the ART market) won't develop”.
While it would be profoundly unwise to disagree with the ceo of XL Capital Ltd. there is a wider picture to be considered here. If XL Capital had not been successful in securing a solution from the capital markets in the previous year would Berkshire Hathaway have offered retrocession, a competing conventional product, in the subsequent year? By going to market for this product XL Capital created two new sources of potential solution - one from the capital markets and, in the subsequent year, a solution from the conventional reinsurance market.
It logically follows from Mr O'Hara's remark that once rates harden in the conventional markets opportunities will open up for the alternative market.But price is not necessarily the key issue where more broadly structured ART products are under consideration with no equivalent in the conventional market or which incorporate conventional market products. Examples would include structured finance, corporate finance and project finance transactions where conventional insurance may be a component alongside capital markets' risk transfer and risk financing techniques. Solutions drawing on a combination of insurance and capital markets products offering broader transfer or financing opportunities than those available from the conventional market alone will be less price sensitive and may represent the way forward for ART in a soft conventional market.
When compared to the transactional costs of traditional insurance the higher costs of bespoke alternative risk transfer and financing transactions have until recently restricted their use to high value transactions capable of bearing these increased costs. It is for this reason that the focus of transactions has been on the higher value end of the market. As more ART deals are done so the number of templates and models increases, producing a return on the heavy research and development involved in early ground breaking transactions. It would be interesting to compare the costs today of, say, repeating the St Paul-Georgetown Re insurance securitisation against those incurred in 1995 when it was the first transaction of its type. There have already been a considerable number of transactions employing ART at much lower levels of risk, down to $25 million in the author's experience, employing experienced advisers who do not have to incur the costs of “reinventing the wheel”. The future of ART lies more in originating transactions at these lower “working levels” of risk than it does in the higher level publicity stealing deals.
The ART market in the year 2000 and beyond will have to overcome a number of regulatory hurdles, whether imposed by insurance regulators or statutory accounting treatment. Witness the debate surrounding the introduction in the US of Financial Accounting Standard 133, Accounting for Derivative Instruments and Heading Activities scheduled to take effect in the year 2000. The market generally drives the regulatory debate and the level of activity among regulators to facilitate ART transactions is remarkable. A number of European countries are changing their laws to permit securitisation of assets not backed by the income stream from mortgages. Protected cell company laws have been promulgated in Illinois, Bermuda and Jersey among other places. Glass Steagal is under review although the outcome is presently inconclusive. Captives can now be established at Lloyd's. Regulatory constraints and the absence of regulations facilitating certain types of transactions certainly represent an inhibitor of the growth of ART yet there are encouraging signs that they are being addressed by key regulators in a constructive pro-integration manner.
In the world's major corporations the demand is increasingly to focus at main board level upon the protection of shareholder value through balance sheet protection. This demand will be supplied through the broader range of products in the ART market which include both conventional and non-conventional risk transfer techniques.
The development of ART is market driven. The absence of facilitating regulation and the other constraining factors noted above, will delay but not ultimately prevent the development of this, as yet, immature market, particularly when what is on offer is the most efficient use of capital.
Patrick Devine is a partner in the London office of Akin, Gump, Strauss, Hauer & Feld. The views expressed are personal to the author and do not represent the views of the partners of Akin, Gump, Strauss, Hauer & Feld.